What is alpha? It’s the first letter of the Greek alphabet of course, and in the fund investment world it’s usually understood to mean “outperformance”. But there’s much more to it than that.
Morningstar’s glossary defines alpha as the “effectiveness” of a fund, as measured by the difference between actual and expected returns. The level of risk taken (beta) is a key factor.
It’s seen as a scorecard of manager skill, as the glossary explains: “Alpha gauges how well a manager can pick stocks.”
“A positive alpha indicates the fund has performed better than its beta would predict. In contrast, a negative alpha means the fund performed worse than expected given its beta.”
Alpha is also measured after fees, an important metric for Morningstar. This means the fund must overcome its costs as well as risks to have positive alpha.
Alpha is connected closely to beta, the second letter in the Greek alphabet. Beta measures an investment's volatility in relation to a market index. When the index rises, a fund with a high beta should gain even more. The reverse should also apply.
How to Calculate Alpha
First find how much a fund and its benchmark have returned (on a monthly basis) over the return of a guaranteed risk-free investment (government bonds are often used for this). You then find the expected return for the investment by multiplying the fund's beta by the benchmark's excess returns. 3-year alpha and beta data can be found on the Morningstar website under “Risk and Rating” as part of “Modern Portfolio Statistics” – here’s an example. It’s usually expressed as a number rather than a percentage.
What You Need to Know About Alpha
A higher beta (higher risk relative to an index) does not necessarily equate to higher alpha (greater return for that risk). A high beta fund may have a negative alpha because it has a higher hurdle to overcome to beat the benchmark.
Not all alphas are equal. The difference between the fund's actual and expected return is its alpha. If alpha is positive, it means that the fund beat its expected return. But two funds could have the same returns, but their differing risk levels will lead to different alphas.
Alpha depends on beta. Both are of limited use if a fund doesn't have a high correlation to its benchmark. This would make the alpha and beta numbers unreliable.
Alpha is not forward looking and its predictive ability is far from guaranteed. A fund's high alpha may be down to managerial talent, but it could also be the result of fortunately timed stock picks or sector bets. For example, any manager with a weighting towards Tesla in 2020 did very well after the stock soared more than 700%.
Negative alpha is not always bad. Alpha fails to distinguish between underperformance caused by poor stock picking and underperformance caused by fees. For example, index funds may have negative alpha because of the drag of expenses, even though these are relatively low. These funds can still be worthwhile core holdings.
Some Quirks of Alpha
Surely all investors will be seeking out high-alpha funds? After all, these are delivering returns higher than average, given the amount of risk they assume.
While beta can be explained by returns linked to the market, alpha is the unexplained element, the dark matter of investment excellence. It’s why investors are happy to pay higher fees for actively managed funds, especially those run by “star managers”.
But for alpha to be a reliable measure, it needs to be considered in close proximity to beta. It’s also a blunt measure because it can’t distinguish between the causes of underperformance, whether that’s fees of poor managerial skill. Because managers of index funds don't select stocks, they don't add or subtract much value, and may score badly on an alpha measure. But in absolute terms they may outperform active managers consistently over the long term.
Alpha is also a short-term measure that can change over the time. High-alpha managers may appear to be geniuses, or they could just be lucky. A positive alpha today may turn into a negative alpha tomorrow.
